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PORTFOLIO ANALYSIS
(Cont)
Security analysis recognizes the key
importance of risk and return to the investor.
PORTFOLIO ANALYSIS
(Cont)
Given an estimate of return, the analyst is likely
to think of and express risk as the probable
downside price expectation (either by itself or
relative to upside appreciation possibilities).
Why portfolios?
The simple fact that securities carry
Diversification
Efforts to spread and minimize risk take the form
of diversification
Portfolio Construction
Investment decisions are all about making
choices: Will income be spent or saved?
Portfolio
Construction(cont)
Savings are invested in various assets
Possible Investment
Goals
There are many reasons for saving and accumulating
assets:
Start a business
Funds to meet emergencies
Funds to finance education expenses
Funds to make a specified purchase (e.g., a home; make
a downpayment on a house)
investor (Cont..
Financing a retirement or a childs education,
have a longer and more certain time horizon.
The investor knows approximately when the
funds will be needed and so can construct a
portfolio with a long-term horizon. Bonds that
mature when the funds will be needed or
common stocks that offer the potential for
growth would be more appropriate than
savings accounts or certificates of deposit
with a bank.
goals of the
investor (Cont.
portfolio-
Taxes
Diversification and
Asset Allocation
To achieve diversification, the returns on your
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Diversification and
Asset Allocation(Cont)
Individuals use their finite (limited) resources to
acquire various types of assets. E.g : Allocation of
assets among alternatives such as stocks, bonds,
and precious metals, and real estate.
Asset
Allocation(Cont)
Asset allocation and diversification are
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Asset
Allocation(Cont)
Diversification is important because it
reduces the investor s risk exposure.
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Portfolio Assessment
Popular press places emphasis on return.
Higher return requires accepting more risk.
Assessment should consider both the return and
the risk taken to achieve the return.
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Investment philosophy
Belief that investment decisions are made
in exceedingly competitive financial
markets. Information is disseminated so
rapidly that few investors are able to take
advantage of new information.
Investment
philosophy(Cont)
Understanding yourself and specifying goals
is important when developing an investment
philosophy and making investment
decisions.
The Internet
Major source of information concerning investments:
http://www.investopedia.com ; http://www.TeachMeFinance.com
http://www.bloomberg.com ; http://money.cnn.com;
http://www.fobes.com
http://www.google.com; http://www.marketwatch.com
http://www.morningstar.com ; http://moneycentral.msn.com/investor
http://www.investor.reuters.com ; http://finance.yahoo.com
http://www.cma.org.rw
Portfolio Theory
Portfolio Theory is built around the investor
seeking to construct an efficient portfolio that
offers the highest return for a given level of risk or
the least amount of risk for a given level of return.
Theory(Cont)
1. A measure of the dispersion of a set of data from its mean. The
more spread apart the data, the higher the deviation. Standard
deviation is calculatedas the square root of variance.
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Theory(Cont)
The contribution of Markowitz was a major advance
in finance and led to the development of the
Capital Asset Pricing Model (CAPM) and
subsequently to the arbitrage pricing model,
generally referred to as arbitrage pricing theory
(APT).
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Portfolio
Theory(Cont)
Arbitrage pricing theory(APT), initially developed by
E.g, if IBM stock is selling for $50 in New York and $60 in
San Francisco, an opportunity for riskless profit exists.
Arbitrageurs would buy the stock in New York and
simultaneously sell it in San Francisco, thus earning the
$10 profit without bearing any risk.
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Map
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Figure 2 Indifference
Map(Cont)
Each indifference curve represents a level
Figure 2 Indifference
Map(Cont)
The additional return is sufficient to induce bearing
the additional risk, so the investor is indifferent
between the two alternatives.
Figure 2 Indifference
Map(Cont)
Investors would like to earn a higher return without having to
bear additional risk.
Figure 2 Indifference
Map(Cont)
The investor seeks to reach the highest level of
satisfaction but is, of course, constrained by what is
available.
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Figure 3 Determination of
the Optimal
Portfolio(Cont)
If the investor selects any other portfolio with a
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Figure 3 Determination of
the Optimal
Portfolio(Cont)
Portfolio must be preferred to B, and
because A and B are equal, must also
be preferred to A.
Expected Return
The table below provides a probability distribution for the returns on stocks A
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and B
State
Probability
Return On
Stock A
Return On
Stock B
20%
5%
50%
30%
10%
30%
30%
15%
10%
20%
20%
-10%
The state represents the state of the economy one period in the future i.e. state
1 could represent a recession and state 2 a growth economy. The probability
reflects how likely it is that the state will occur. The sum of the probabilities
must equal 100%. The last two columns present the returns or outcomes for
stocks A and B that will occur in each of the four states.
Expected Return
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E[R] = (piRi)
i=1
Where:
E[R] = the expected return on the stock
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i.
Expected Return
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Expected Return
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Measures of Risk
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Measures of Risk
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Probability Distribution:
State
Probability
Return On
Stock A
Return On
Stock B
20%
5%
50%
30%
10%
30%
30%
15%
10%
20%
20%
-10%
E[R]A = 12.5%
E[R]B = 20%
Measures of Risk
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Where:
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i
E[R] = the expected return on the stock
Measures of Risk
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SD(R) = =
2 = (2)1/2 = (2)0.5
Measures of Risk
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Now you try the variance and standard deviation for stock B!
Measures of Risk
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If you didnt get the correct answer, here is how to get it:
2B = .2(.50 -.20)2 + .3(.30 -.20)2 + .3(.10 -.20)2 + .2(-.10 - .20)2 = .042
E[Rp] = wiE[Ri]
i=1
Where:
Where:
sA,B = the covariance between the returns on stocks A and
B
N = the number of states
pi = the probability of state i
RAi = the return on stock A in state i
E[RA] = the expected return on stock A
RBi = the return on stock B in state i
E[RB] = the expected return on stock B
A,B
Cov(RA,RB)
Where:
A,B=the correlation coefficient between the returns on
stocks A and B
A,B=the covariance between the returns on stocks A and B,
A=the standard deviation on stock A, and
B=the standard deviation on stock B
-.0105
A,B =
(.0512)(.2049)
= -1.00
2p =(.75)22+(.25)2(.2049)2+2(.75)(.25)(-1)(.0512)(.2049)= .00016
p = .00016
= .0128 = 1.28%
Where:
CAPM Example
68
Find the required return on a stock given that the riskfree rate is 8%, the expected return on the market
portfolio is 12%, and the beta of the stock is 2.
bi = 1.33
Note that beta measures the stocks volatility (or risk)
relative to the market.